The nation is closely watching as California prepares to launch its first auction of pollution credits in a groundbreaking cap-and-trade program to reduce greenhouse gas (GHG) emissions, and potentially raise billions in revenue that can be reinvested in programs to reduce pollution and expedite the State’s transition to a clean energy economy.

And if the country’s first cap-and-trade program to extend economy-wide -- covering the electricity, industrial and transportation sectors -- is as successful as anticipated, it likely will become a model for implementation elsewhere.

According to one of the nation's foremost experts on environmental regulation in the electricity sector, businesses and consumers also will benefit under the state’s well-designed strategy to help reduce the carbon footprint of the world’s eighth-largest emitter of greenhouse gases.

“The cap-and-trade approach is more than theory,” Dallas Burtraw told the California Senate’s Select Committee on the Environment, the Economy and Climate Change late last month. “It has been put into practice many times, especially in the regulation of air pollution, and can be attributed with cost savings of billions of dollars compared to traditional regulatory approaches.

“Such cost savings are good for business and consumers; and costs savings are good for the environment because it means society can afford greater emissions reductions,” said Burtraw, who has a long history of studying cap-and-trade programs and is now with the Washington, D.C.-based Resources for the Future research institution.

The California Air Resources Board’s plan calls for auctions of pollution credits or “allowances” to begin this November, with a practice run in August to give all the stakeholders, including the companies that are going to have to be purchasing allowances, an opportunity to see how the system will actually work. The non-partisan Legislative Analyst’s Office estimates the auctions could generate between $660 million and $3 billion for the 2012-13 budget year. (Note the LAO is using higher allowance price assumptions than I used in my previous post).

With so much money at stake, cost management is an important issue but Burtraw said “there are several features of the California program design that will help manage allowance price fluctuations and guard against substantial deviations from the expected cost of the program,” including:

Banking – Emissions allowances can be saved and used in later years, providing an incentive to take advantage of low cost-opportunities when they become available. Burtraw said that also should dampen price fluctuations from potential short-run fluctuations in emissions.

Offsets – The plan includes an ability to use emissions offsets from emissions sources not covered by the cap,such as forestry management, which should expand compliance options “and soften any price swings.”

Price Collar – The price collar includes a hard price floor and a soft price ceiling for allowances. Burtraw said the collar “is designed specifically to constrain fluctuations in allowance prices” and “reflects the best available information about how to design a cap and trade program.”

“Together, these three mechanisms provide strong protection that allowance prices will move within expected bounds, while preserving incentives for innovation and capturing the benefits of market-based regulatory strategies,” Burtraw told the committee.

Under California’s Global Warming Solutions Act of 2006, also known as AB 32, the ARB was directed to set policy and develop a package of clean energy measures to reduce statewide greenhouse gas emissions to 1990 levels by the year 2020. A vital element in meeting that goal is the cap-and-trade program, which is designed to gradually limit carbon emissions from California’s industrial, utility and transportation fuel sectors that account for about 85% of the state’s greenhouse gas pollution.

“The cap-and-trade program is expected to achieve the additional emissions reductions necessary to meet the overall target, and moreover to leave no low-cost emissions behind,” Burtraw testified, noting the Air Resources Board has developed “an excellent up-to-date design for cost management in an emissions allowance market.”

Under cap-and-trade, large polluters must obtain permits to match their emissions (small businesses are not directly regulated under the program), with one allowance equaling one metric ton of GHG. The polluter can only emit pollution equal to the number of allowances it holds. ARB will make some allowances available via state-run quarterly electronic auctions and distribute some for free to mitigate price impacts, provide sufficient transition time and maintain a level playing field for entities that compete with out-of-state emitters.

The pollution “cap” will decline by 2-3% annually through 2020. Fewer allowances will be available every year, requiring polluters to take steps to reduce emissions or pay increasingly higher prices to buy them. In addition, 8% of a company’s emissions can be covered using offsets from ARB-certified projects that promote the development of beneficial environmental projects in uncapped sectors such as forestry management, urban forestry, dairy methane digesters, and the destruction of existing stores of ozone-depleting substances in the U.S.

The initial 2013-2014 compliance phase covers only the electricity sector and large industrial facilities, such as oil refineries and cement manufacturers. Distributors of transportation fuels (including gasoline and diesel), natural gas, and other fuels are included in the second (2015-2020) phase. Ultimately 360 businesses representing 600 facilities will be covered under the program.